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Historic Tax Reform Comes to North Carolina

Gov. Pat McCrory promised voters tax reform. Monday, a deal with the legislature was announced that he says fulfills his promise for North Carolina tax reform.

GOP Gov. Pat McCrory called a tax reform compromise reached with legislative leaders “another historic step to ensure what I refer to often as a Carolina comeback.”

House Speaker Thom Tillis, R-Mecklenburg, said it was proof that that reports of the death of cooperation between the House and the Senate “have been grossly over-exaggerated.”

Senate President Pro Tem Phil Berger, R-Rockingham, called the agreement “a historic day for North Carolina.” Tillis and Berger noted it’s the first time since the Great Depression that state leaders have come together to make fundamental reforms in the state’s tax structure.

Meantime, the nonpartisan Tax Foundation, based in Washington, D.C., said the reform plan announced Monday would leapfrog North Carolina’s business tax climate from 44th in the nation to 17th. North Carolina would trail only No. 15 Tennessee among neighboring states in its tax climate ratings.

The major highlight of the reform plan is a flat rate for personal income tax. Currently, tax rates range from 6 percent to 7.75 percent. Under the proposal, the rate is reduced to 5.8 percent in 2014 and 5.75 percent in 2015.

In addition to rate reductions, certain exemptions are eliminated or reduced. The corporate rate is dropped from 6.9 percent to 6 percent in 2014 and 5 percent the year after. If tax collection triggers are met, the rate continues to decrease by 1 percent each of the next two years.

Democrats are universally opposed to the plan. House Democratic Leader Larry Hall, D-Durham, attacked the legislation as “huge tax breaks to out-of-state corporations and millionaires while balancing those breaks on the backs of the middle class and working families.”

Critics of all stripes have also come forward to downplay the proposal. The Raleigh New Observerquoted one tax expert who claimed “it probably looks more like a tax cut” than full reform. GOP State Sen. Bob Rucho of Charlotte asserted the plan is only “the first itsy-bitsy step toward tax reform.”

Small step or giant leap, there is plenty of evidence to support tax cuts as a way to grow a state’s economy. John Hood, president of the John Locke Foundation, wrote an informative post for the Carolina Journal explaining why:

• If state lawmakers “pay” for lower taxes by spending less on transfer programs such as Medicaid or unemployment insurance, the tax cut is likely to generate higher economic growth in the future. What is more debatable is whether tax cuts “paid for” with lower spending on public safety, infrastructure, or education have similarly positive economic effects.

• Marginal tax rates matter more than average tax burdens. How states raise their revenue matters as least as much as how much revenue they raise. A 1996 paper from the Federal Reserve Bank of Atlanta explains this issue well.

• State tax cuts don’t help the economy by stimulating short-term demand, since governments would otherwise spend the same money on something else that would boost short-term demand (i.e., paying public employees or buying supplies). The main way state economies can benefit from lower or more-efficient state taxes is by reducing the effective tax rate on private capital formation (i.e., dividends, capital gains, and retained corporate earnings). More capital formation in the private sector translates into more companies, locations, technology, jobs, and income growth.

If you want to read about these matters in greater detail, I have a book recommendation. In addition, consider these recent academic studies with a variety of interesting results:

• A 2013 paper in the Journal of Entrepreneurship and Public Policy found a strong correlation between a commonly used index of entrepreneurial activity and state economic growth. The author concluded that state policies such as tax reduction and property-rights protections would boost entrepreneurship and, thus, growth.

• A 2013 paper in the urban-affairs journal Growth and Change found that for most business categories, government-cost variables such as taxes and regulatory compliance are of greater significance to business-location decisions than policy variables such as school quality, public transportation, job training, or proximity to universities. The one area of government spending that did rank high was infrastructure, particularly roads. Of course, non-policy variables such as labor availability were among the highest-ranked factors.

For more examples and additional context, check out Hood’s full commentary.